There are always tax implications involved when selling a business. The key is to do your homework up front to understand what those implications may be for your specific situation and to ensure you are paying the minimum amount of tax possible on the transaction. Here are answers to three common questions we receive from clients when selling their businesses which have been operated in corporate form.
What are the key elements in determining how much tax I will pay?
Lowering the tax bill arising from a sale generally involves three principal components:
- If the corporation has not made an election to be treated as a pass-through entity, structure the sale to avoid double tax to the extent possible (i.e. tax paid first at the corporate level and then at the shareholder level). Covenants not to compete and remuneration to owners of the business for post-sale services are common tools which help to address this issue.
- Consider whether the allocation of assets is likely to be treated as capital gain or ordinary income. Capital gain income is currently taxable at a maximum Federal rate of 20 percent with the possibility of an additional 3.8 percent Medicare investment property tax in some cases. Ordinary income, on the other hand, can be taxable at a maximum Federal rate of 39.6 percent, a hefty increase in the amount of potential tax. Higher value allocation to goodwill producing capital gain and lower allocations to fixed assets and other assets which may generate ordinary income are common techniques.
- Arrange the timing of income recognition to fall into a tax period in which a materially lower tax rate may apply. The concept here is to spread income recognition out so the seller’s applicable marginal tax bracket may be lower than if the income were bunched in one year. Installment sale tax provisions can assist in this area.
Why don’t I simply sell my stock? Wouldn’t this result in the entire gain being treated as capital gain and therefore avoid any possible double tax issues?
This can be a good approach, provided the buyer agrees to it. However, in many cases a buyer is trying to minimize his or her own tax bill. So, the buyer may seek to reduce the purchase consideration to reflect perceived tax benefits given up by losing the opportunity to step-up post-acquisition tax basis in assets owned by the company whose stock is purchased.
Can I sell my stock and still allow the buyer to get his desired step-up in tax basis?
Yes, and this is a common approach used in the sale of stock of a company that has elected to be taxed as a pass-through entity. The technical term for this is a Section 338(h)(10) election, through which the seller and buyer agree to treat the sale of stock as if the company first sold its assets and then made a liquidating distribution of the net proceeds to owners. We’ll take a closer look at this topic in a future blog post.
These transactions can become complex, particularly from a tax standpoint. If you have any questions or would like to discuss your individual situation in more detail, please don’t hesitate to contact me.
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